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Real Options and Risk Dynamics

We examine the asset pricing implications of a neoclassical model of repeated investment and disinvestment. Prior research has emphasized a negative relation between productivity and equity risk that results from operating leverage when investment is irreversible. In general, however, expansion and contraction options affect risk in the opposite direction: firms become safer as profitability declines. The general prediction is a nonmonotonic overlay of opposing real option and operating leverage effects. For parameters chosen to match empirical firm characteristics, the predicted nonmonotonicities are quantitatively important, and are present in the data. Both the calibrated model and the return data suggest real option effects dominate operating leverage effects, and the average firm is best described by an increasing risk profile. The calibrated model helps explain the profitability premium in the cross-section, but makes the value puzzle worse. Panels with heterogeneous firms can deliver simultaneous profitability and value effects that match empirical levels.